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Protect yourself with DAA

Supposedly uncorrelated assets can end up falling at the same time as each other. One technique offers a different way to protect capital.

Summary:The financial planning industry is dominated by “strategic asset allocation” thinking, which argues that different asset classes are not correlated to each other and constructs portfolios that are diversified across asset classes. But In the GFC, historically uncorrelated assets largely fell at the same time as each other. A number of “dynamic asset allocation” products offer a different approach – selling down assets and moving to cash in times of heightened risk.

Key take-out: Our research shows a portfolio of five DAA products protected capital better than the Morningstar Balanced Index, the industry benchmark for balanced portfolios.

"How will an adequate flow of income be generated for the retired community in the future, in a world in which long-term nominal returns on low-risk assets are so low… (investors) have to accept a lot more risk to generate the expected flow of future income they want."

(Glenn Stevens, RBA, April 2015)

“The hunt for yield among (retirees) seeking a reasonably comfortable life is truly heart-breaking.”

(Alan Kohler, June 2015)

The question of portfolio construction is key for retirees, particularly the many who have been forced into the corner of using stocks to generate retirement income and have watched the Australian share market fall this year. Asset allocation is a hot topic, especially after the GFC showcased the risky flaws in traditional portfolio construction concepts. Supposedly diversified portfolios built using historically uncorrelated assets fell savagely, with all assets (other than Government bonds) showing very high correlations with each other. Weaknesses were exposed in the idea that risky “growth” assets could be counter balanced with less risky “defensive” assets, for a smooth ride and consistency of returns.

At Eureka Report, we have previously discussed “objective based” investing, sometimes known as “dynamic asset allocation” or “DAA” (see DAA: A new investment approach, May 20 and Correction protection: The scorecard, July 22). This week we look at how careful blending of “objective based” or “DAA” investments can improve portfolio returns, reduce risk and minimise drawdowns in negative markets.

SAA and the correlation myth

The idea behind “strategic asset allocation” is that different asset classes are not completely correlated to each other, and that changes in their values, risk and returns can be predicted.

SAA then builds on these two ideas to construct “diversified” portfolios with graduated risk profiles (to suit specific investor’s needs), with adjustments made periodically as market conditions change.

The financial planning industry is dominated by SAA thinking, which goes to the extent of propounding that SAA based portfolios are “optimally efficient” – i.e. that there is no better way for an investor to build and provide for their retirement. For investors and advisers who are defined by that approach, across the board falls in asset classes during market crashes are unavoidable (see Figure 1).

Figure 1: Asset class returns 2008. Source: BetaShares.

The best that can be said within that paradigm is that by waiting long enough, asset prices will recover. Chart 1 shows how long that recovery can take. It also shows the wild fluctuations in returns that portfolios built using SAA have generated over the last 100 years. The problem doesn’t just arise when extreme GFC style events occur: it’s a permanent fixture of this concept.

Managing sequencing and longevity risk

Of course, not all retirees can wait for their retirement portfolio to recover in value. The wealthy can, but “mainstream Australians” with median SMSF balances of around $500k are decimated by volatility. Mandatory SMSF capital withdrawals starting at 4 per cent in pension phase, and rising with age, further erode the investor’s capital base after market crashes.

For those who have lost faith with traditional SAA based “balanced” portfolio construction, the choice is often between chasing high returns through equities and accepting inadequate returns from cash and TDs. With such limited tools it’s hard to avoid sequencing risk on the one hand, or longevity risk on the other:

Figure 2. Source: BetaShares

DAA based portfolio construction

The growing range of investment products based on dynamic asset allocation provides investors with a variety of tools to help break this impasse. The essential logic behind DAA investments is that markets are not consistently predictable and that volatility can be reduced and returns stabilised by having the flexibility to sell down assets and move to cash in times of heightened risk.

There are two main ways of implementing this strategy:

Specifically targeting a nominated return (eg CPI 5 per cent pa) and selecting the lowest risk assets available to achieve that return (with increasing allocations to cash during periods of heightened risk). This is the approach adopted by Schroders in its “Real Return” fund;

Specifically targeting a maximum level of risk (volatility) and selecting the highest returning assets available to achieve that risk (again, with increasing allocations to cash during periods of heightened risk). This is the approach adopted by AMP in its Dynamic Markets Fund.

While the use of cash as a “risk off” tool is a common theme, each of the major providers rely on their own models to select assets and to trigger their sell down as risk rises. This is where the real test arises, as to be effective these models inherently must use historical data to predict changing conditions. Tools like Robert Shiller’s “Cyclically Adjusted Price/earnings Ratios” feature in the design of these investments, as well as proprietary and closely guarded technology which the product manufacturers hope provides an investment edge.

Because of this diversity, it’s sensible to build an “objective based” or “DAA” portfolio using a variety of different providers and styles. For our analysis this week, we looked at five products, two of which are issued by global investment houses and three of which are managed by local family offices. The results show that the Blended DAA model portfolio provided clear and measurable improvements compared to traditional portfolios.

Figure 3: Drawdown comparison

Figure 3 compares the performance of the Blended DAA Portfolio compared to the Morningstar Balanced Index (the industry accepted benchmark for balanced portfolios constructed using SAA methodology). We can compare the performance of each option by considering its “drawdown”, or capital loss – remembering that the less a portfolio falls during market volatility, the quicker it can recover.

The Morningstar Index (which doesn’t include fees) experienced a maximum “one off” drawdown of -4.9 per cent in the period since 30 September 2009 (that drawdown occurred in September 2011). In comparison:

The cumulative maximum “one off” drawdown of the Blended DAA Portfolio in the same period was 3.2 per cent (an almost 40 per cent improvement compared to the traditional SAA balanced fund). All data for the Blended DAA Portfolio is net of fees.

That is over a 40 per cent reduction compared to the cumulative drawdown of the Blended DAA Portfolio and over a 60 per cent reduction in drawdown compared to the traditional SAA balanced fund.

At the time the Morningstar Balanced Index had a maximum drawdown of 4.9 per cent (Sep 2011) the Blended DAA Portfolio did not experience any drawdown at all.

The diversification benefit to the blended DAA Model (of 1.4 per cent) reduced the maximum drawdown to 1.8 per cent. This drawdown occurred in June 2010 during which time the Morningstar Balanced Index experienced a 3.3 per cent drawdown.

Figure 4 shows the improvement that the Blended DAA Model provided during the period compared to the Morningstar Balanced Index.

Figure 4: Blended DAA Model vs Morningstar Balanced Index.

Where to from here?

For discerning investors an allocation to a blend of DAA investments can help reduce the risk of a heavy weighting towards income generating Australian shares, and offers a good alternative to low cash rates and uncertainty around fixed interest assets. The amount allocated should reflect individual investor’s circumstances, including:

Total value of investment portfolio (i.e. how comfortable are you now?)

Perception of future investment risks (i.e. how bad do you think the markets may get over the rest of your life?)

Age and life expectancy (i.e. how likely are you to run out of money before you pass away?)

As an advance compared to traditional SAA portfolio construction, “objective based” or “DAA” style investments show clear evidence of outperformance over the last six years. History of course isn’t an infallible guide to the future, but it can be a good mentor for you.

IMPORTANT: This information is general financial product advice only and you should consider the relevant product disclosure statement (PDS) or seek professional advice before making any investment decision. Product disclosure statements for financial products offered through InvestSMART can be downloaded from this website or obtained by contacting 1300 880 160. You should consider the product disclosure statement before making a decision about a product. All indications of performance returns are historical and cannot be relied upon as an indicator for future performance.